What is Kelly criterion betting, and how to use it in crypto trading?

The Kelly criterion, a mathematical strategy that revolutionized gambling and investing, was applied to optimize bet sizes for maximizing long-term wealth. The formula calculates optimal bet sizes based on winning probabilities, but its practical application requires adjustments for transaction costs and psychological factors in volatile markets like cryptocurrencies.

This article will explain what Kelly criterion is, how it works, how it can be used in crypto trading, juxtaposition with the Black-Scholes model, and the associated benefits and pitfalls.

What is Kelly criterion betting?

The Kelly criterion is a mathematical technique used in gambling and investing to calculate the ideal size of a sequence of bets. Its fundamental idea is to minimize the chance of financial risks while increasing the rate at which capital grows over time. The algorithm takes into account the likelihood of winning or losing a bet in addition to the potential profit-to-loss ratio.

The Kelly criterion’s central tenet is to allocate one’s capital among bets according to the bet’s edge or advantage and the available odds. The goal of the Kelly criterion is to maximize growth while minimizing risk by assigning a portion of the capital to the edge.

A good Kelly ratio refers to a bet size that maximizes the predicted logarithm of wealth and yields the strongest long-term growth rate. It is imperative to acknowledge that although the Kelly criterion presents a theoretical ideal approach, in practice, adjustments may be necessary to accommodate variables including transaction expenses, estimation uncertainty and psychological aspects.

History of the Kelly criterion

The Kelly Criterion, named after its creator, John L. Kelly Jr., was formulated in 1956 during his tenure at Bell Laboratories. Its use quickly spread to gambling and investing from its original purpose of optimizing the signal-to-noise ratio in long-distance communications.

However, these fields only became aware of it later, mostly because of mathematician Edward O. Thorp’s efforts. Through the application of the Kelly criterion to blackjack card counting in the early…

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